IRS Information, Regulations and Commentary on Charitable Legal Issues

Making Your Charitable Trust Mimic a Pension – Vaughn Henry & Associates

Making Your Charitable Trust Mimic a Pension – Vaughn Henry & Associates

Make that Charitable Trust Act like a Pension

Vaughn W. Henry © 1999

If you think Patrick Henry’s, “taxation without representation” is meaningful, imagine how he’d feel about our “taxation with representation”.

Once upon a time, pension experts promoted tax deferred retirement plans as a way to grow an estate. Their sales pitch was, “whatever you don’t use in retirement will be available for your kids.” Then, when it became apparent business owners were setting aside too much for themselves, the Department of Labor and ERISA/IRS regulations mandated a whole list of rules that made discriminatory retirement planning a thing of the past. To heap further problems on the pension owner, Congress changed the estate tax treatment of retirement accounts in 1981 to eventually make them completely taxable at both the income and estate tax level by 1986. In some areas of the country, it was possible for a family to owe more than 100 cents tax on every inherited dollar, so in today’s planning environment, a different approach to retirement planning has become more popular. Enlightened estate planning promotes the concept of regaining control over dollars that otherwise are lost to the tax system.

Depending on the performance and nature of the investments used, a charitable retirement unitrust might make use of new flip trust regulations and have more income with capital gains treatment on the deferred income stream. The alternative approach is to use a specially designed deferred annuity inside a §664 charitable remainder trust (CRT) to more precisely control the timing and recognition of distributable net income (DNI) and make it a spigot trust. WIFO* (worst in, first out) four tier trust accounting can be manipulated if there is a complete understanding of the investment choices inside CRT funded with cash.

Gerald (50) and Susan Warren (49) have a successful partnership as business brokers and consultants. While they have a fully funded profit sharing and pension plan, they decided to look into other retirement planning tools that offered a different sort of control. The Warren’s dissatisfaction with their existing plan became apparent after they saw how the required minimum distributions would force out income when they wouldn’t need it and the eventual confiscation of their savings. Originally designed to provide security in retirement and create an estate for their heirs, instead after a series of legislative changes, it looked like the IRS is the major beneficiary of their retirement planning.

With a degree in law, Gerald looked into using a charitable trust to mimic his pension plan and decided to make use of a net income/make-up charitable remainder unitrust (NIMCRUT). Although not every contributed dollar is 100% deductible, the flexibility and personal satisfaction of knowing their social capital dollars will be redirected was motivating. Once they acknowledged that taxes are a form of involuntary philanthropy, the §664 CRT made more sense within their master plan and they proceeded with the trust. Since Gerald plans to work full-time at least through age 68, the Warrens decided to set aside $50,000 a year for contributions to their retirement unitrust. Over the next 18 years, a total of $900,000 will be saved inside a tax-exempt trust that generates $163,012 in tax deductions. When the retirement CRT or spigot trust opens up in the 19th year, the Warrens can expect to receive $4.33 million (based on past investment performance) in after-tax income during their retirement. After Gerald and Susan pass away, at their joint life expectancy, the trust will transfer $7.81 million to their community foundation’s donor advised account for their children to manage and distribute. This trust, combined with a wealth replacement trust for their heirs, will leave the family in control of the Warren estate and produce a “Zero Estate Tax Plan” that suits their planning goals with a family financial philosophy of wealth preservation and charity.

For those who would prefer to use a conventional pension plan, if the same NIMCRUT input assumptions are used, the tax liability at life expectancy would be a staggering $5.899 million and the total spendable income would not be significantly different. Clearly, a charitable trust as a retirement planning tool is worth consideration for individuals with charitable intent and a desire to retain control of family wealth.

Pension §664 Trust
Deductibility Full Partial
Tax Advantaged Growth Yes Yes
§415 Limitations Yes No
Assets Subject to Estate Tax Yes No
Non-Discrimination Rules Yes No
Early & Late Retirement Penalties Yes No
Required Minimum Distributions Yes No
Taxation of Distributions Ordinary Income WIFO* Acctg.
Benefits to Heirs Yes Optional
Heirs’ Benefits Taxed Yes No